Jumping Over Firewall Into Brazil, Global Crisis
Escalates to Most Serious Level Yet

By

William Pesek Jr.

Updated Jan. 18, 1999 12:01 a.m. ET

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J ust when it seemed safe to go back into the global capital markets, Brazil reminded us that things are far from placid. By letting its currency slide, the world's ninth-largest economy put the international financial system back on the brink of turmoil. In fact, Brazil has raised the global crisis to its most serious level yet.

For the U.S., Brazil's problems are decidedly bad news. They put the financial chaos that sank Asia directly into America's backyard. While Asia's problems and Russia's meltdown did modest damage to the U.S., a meltdown in Latin America's largest economy certainly would hit home.

Considering the beating emerging markets took after Russia's implosion, it's not hard to understand why money fled Brazil last week, as well as emerging-market bonds in general. Washington was hit with a similar case of deja vu . Treasury Secretary Robert Rubin and his aides worked the phones, conferring with officials in Brasilia and members of the Group of Seven.

Indeed, they have much riding on Brazil. When Treasury officials signed on to a $41.5 billion International Monetary Fund aid package last November, the idea was to hold the line with Brazil. By building a firewall of sorts, Washington hoped to turn the tide against a crisis that won't go away. The plan also was to protect U.S. exports and reduce risks for banks and corporations with heavy exposure to Brazil and its neighbors.

Now that things are unraveling, the risk is that Latin America could be to the global economy in 1999 what Asia was last year. As with all types of financial crises, there comes a point where problems on the periphery begin to drag core economies down with them. With Brazil, it's possible that stage is being reached. "Brazil is a very important economy," Rubin said in a recent interview. "It's very important to the hemisphere and it's very important to us. Clearly, it's key that they proceed with their reforms."

Brazil's abrupt move to let the real slide by 8% prompted the head of its central bank, Gustave Franco, to resign, which only accelerated the erosion in investor confidence. The new central bank president, Francisco Lopes, opted not to prop up the real Friday, allowing it to float. Indeed, Brazilian authorities figured they would just end up wasting much of the country's estimated $32 billion of foreign-currency reserves. And immediately, markets rejoiced that Brazil had done the inevitable and removed a cloud of uncertainty.

But this sense of relief ignores that the real's slide is a symptom of Brazil's problems, not the cause. Oppenheimer fund manager Art Steinmetz, after meeting with Brazilian officials -- including finance minister Pedro Malan -- in Brasilia and Rio de Janeiro last week, finds the market's complacency unsettling. With the devaluation, he says, "one of the pressure valves blew, but the big problems aren't being fixed." The problem, Steinmetz asserts, is that Brazil is "moving way too slowly and not boldly enough" to correct imbalances in the economy, particularly on the fiscal front.

What the limited devaluations in Mexico in 1994, Thailand in 1997, and Russia in 1998 had in common was that they were considered minor events with relatively few implications for the world economy. With the benefit of hindsight, we now know that Mexico took the rest of Latin America with it days later. And that Thailand dragged Southeast Asia into turmoil within a couple of months. More recently, few thought Moscow's devaluation last August would bring the entire global financial system along for the ride, sink Long-Term Capital Management or lead the Federal Reserve to cut rates three times with U.S. unemployment at 25-year lows.

The lesson here, notes Greg Jones of briefing.com, is that while Brazil hasn't had disastrous consequences yet, it still might. For example, what if Mexico, Argentina, Venezuela and the rest of the region experience a capital flight and sky-high interest rates? What kinds of contagion risks might flow from Brazil?

IMF officials, who were unhappy that Brazil had devalued without appearing to have a coherent plan for the future, will meet with Brazilian officials this week. The situation they face is one of Latin America edging toward recession. If Brazil's government loses its grip on the economy, a contraction on a par with 1995 is possible. After all, Brazil still has a massive budget gap, an emerging inflation problem and deteriorating investor confidence that may cut off the crucial inflow of capital.

Paying back dollar-denominated debt will be more difficult. Brazil needs to roll over $9 billion of domestic debt this month, $12 billion next month and $15.4 billion in March. But it has external obligations of roughly $230 billion, of which $145 billion is owed by the private sector. This debt burden leaves the country disturbingly vulnerable if a loss of investor confidence keeps interest rates high.

All of this is bad news for the U.S. economy and the Dow Jones Industrial Average, but good news for U.S. Treasuries. A Brazil in turmoil would be big trouble for the rest of a region that accounts for 20% of U.S. exports. But the drop in Treasury yields may be delayed, or at least slowed, by recent volatility in the dollar.

The dollar hit a 28-month low of 108.22 yen, prompting the Bank of Japan to intervene in currency markets to halt the surge in the yen's value. Reassurances from Rubin that the U.S. still favors a strong dollar, coupled with the intervention, pushed the dollar sharply higher on the week. It closed Friday at 114.10 yen, up from 110.80 a week earlier. Meanwhile, the 30-year bond yield ended the week at 5.12%, down from 5.28% a week earlier.

But the greenback remains susceptible to woes in Brazil, owing largely to the fact that many key U.S. companies are vulnerable to the country's financial ills. Concerns about international market liquidity is another potential negative. Declining liquidity could undermine the dollar and the currencies of other countries dependent on capital inflows to fund large current-account deficits. That of the U.S. could soon hit $300 billion.

Of course, underlying U.S. fundamentals are providing support for the dollar. Growth is strong, as evidenced by the 0.9% jump in December retail sales. Meanwhile, consumer prices were up just 1.6% in 1998, the slowest rate of advance since 1986. Given the lack of inflation, U.S. monetary policy and long-term rates should maintain an easier bias.

While it's unlikely to cut rates for fear of fueling stocks higher or over-stimulating the economy, the Fed stands ready to save the world from chaos, as it did in 1998. Fed Chairman Alan Greenspan no doubt will address the issue when he heads to Capitol Hill Wednesday to discuss the state of the economy.

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